Are You Tax-Diversified?

You’ve likely heard of the importance of investment diversification. Putting money in different types of stocks and bonds helps minimize risk, so if some of your investments decline, others may increase in value and soften the blow of any losses. What’s not given much attention — but is also important to your finances — is tax diversification.

This means spreading your investments among accounts that are taxed differently, allowing you to better manage your tax bill after you retire. 

There are three types of accounts:  

• Taxable. This includes bank and brokerage accounts, in which you pay taxes on the interest or dividends you earn each year or when you sell securities and recognize a capital gain. 
• Tax-deferred. These accounts include a 401 or 457 plan, or traditional IRA. Your contributions are either made on a pre-tax basis (401 or 457 plan) or may be tax deductible (traditional IRA). Your investments grow sheltered from taxes until you start withdrawals in retirement, at which time they’ll be taxed as ordinary income. Though you can defer taxes on this money for decades, once you turn age 72 — under a new law — you must start Required Minimum Distributions (RMDs) from these accounts annually and pay taxes on the money.
• Tax free. A Roth IRA falls into this category. You don’t get a tax break upfront, but your withdrawals will be tax-free in retirement — and there are no RMDs. (Roths are recommended especially for younger workers who are in a low tax bracket today but likely to be in a higher one in the future.)

The importance of tax diversification becomes most evident in retirement. For example, retirees who hold most of their savings in tax-deferred accounts could be pushed into a higher-tax bracket once they start taking taxable withdrawals. But by building savings in accounts with different tax treatments, you will be able to plan future withdrawals to minimize the tax bite. Check with your accountant or financial advisor for help on creating a tax-diversified portfolio that’s best for you.